Mike Lipper's Blog

Sunday, July 26, 2015

For some time I have
been worried about a market top in stocks. In a classic sense, a major decline
is less likely today for structural reasons than I had previously thought. Two
obstacles to higher stock prices are Politicians and Commodities.Both ofthese drawbacks are reversible, but could cause the “once in a generation fall” of
my fears.

The
Enemy = Politicians

All politicians, as distinct
from statesmen or stateswomen, wish to avoid being tagged with unpopular
political decisions. The very nature of human and animal life is one of
periodic successes and failures. A student of financial history recognizes
peaks and valleys. The current crop of political leaders recognize that job
preservation and job creation are critical to their reelection. To deliver on
these goals they have adopted a policy of bailing out large employers who have
sufficiently poor financial conditions that there is fear of substantial job
losses. Such bailouts ignore the historical fact that it is natural for businesses to expand and contract, and in many cases particularly good for their customers. When a
significantly large number of voters in key areas are employed by a company
that is in distress, the modern reaction is to bailout the troubled company or
industry with taxpayer money.

The recognized problems
of late 2007 and 2008 in the US led to massive bailouts of both major auto
makers and very large financial institutions. The public was revolted by this
use of its hard earned money in the face of needs for spending on
infrastructure, education, and defense. To avoid future bailouts and to protect
themselves, the politicians came up with the doctrine of preventing large
corporations from becoming “too big to fail” so that the government would be
politically forced to bail them out. From the standpoint of protecting the
politicians, the various “reforms” such as the Dodd Frank legislation appear to
be doing a good job currently, as we have not had a major failure since the
financial crisis.

The
Price

To fund the bailouts,
the Federal Reserve bought almost all of the debt the federal government put
out and in so doing increased money supply which led to materially lower
interest rates, particularly hurting the retired population, living on fixed
income returns from their savings and pensions.

As harmful as that policy
was to an important part of the population, a much bigger price was paid by the retail
investor. Over the five years that the Dodd Frank bill has been operating there
has been a withdrawal from individuals buying individual stocks. This has been
caused by two simultaneous elements. The first by making the investment
community seem to be the sole source of the financial crisis without regard for
the contributions of government policies, labor unions, and inappropriate
education. By demonizing the financial
community many otherwise rational investors voted with their feet. In the past,
this kind of withdrawal would have brought a response from the financial
community.

Because of greatly
increased regulation on large financial institutions they needed to add highly
paid compliance people and capital buffers that made the cost of serving the
middle income public sky-rocket.

For many brokerage
firms, the retail cash agency business has become unprofitable. This in turn
has led to a change in the nature of the sales force serving the public. They
have shifted into selling packaged products that have higher margins and often
include borrowing (leverage). This shift has led to a number of the older and
more trusted sales people leaving to become fee-paid advisors, replaced with
younger sales people with increased sales quotas (this did not sit well with established
clients or younger would be-investors). The net result is that far too many
investors did not benefit from the doubling of market prices over the last five
years. Their absence is being felt today by their lack of enthusiasm for
investing to meet long term retirement needs.

Despite various
politicians’ beliefs, human nature has not been repealed. Eventually the animal
instincts will drive greed over fears and we will get enthusiasm for risk
taking. While it is likely to be more muted than what we have seen in China, it
will become a force that will override the damage to investors’ psyche caused
by the Dodd Frank bill.(Retail
investors own 80% of the small Chinese market often with substantial margin
debt. The Asian institutional market is a heavy user of equity derivatives
which did not help in the last couple of weeks.)

Commodities,
the Second Reversible

I have not owned any
commodity future for more than thirty years. Nevertheless, whenever I see the
media coverage of a major decline with the expressed view that it will
continue, my investment instinct is to look for exhaustion on the part of the
late sellers which will create a bottom. To most investors, commodities and
particularly futures are of little importance in developing longer term
investment policies. With high quality interest rates being manipulated by the central banks, I wonder whether the fixed income market will continue to serve
its historic role of alerting the equity market of on-coming problems. If that
is the case I am beginning to examine whether there is useful information in
commodity prices.

According to Calafia
Beach Pundit, while commodity prices are down they are still substantially up
from their bottom. For example, Copper, often called Dr. Copper because of its
economic ties, is down 40% from it peak but still 290% above its 2001 bottom.
The price of commodities is a function of perceived and actual scarcity. One of
the students of commodities recognized that in truth, the only scarcity of mankind
is “human ingenuity.” Over time technology has eaten away at the use of any
commodity through improved mining and manufacturing techniques plus growing
substitution of less expensive elements. Also history reminds us that higher
prices bring out more supply including new discoveries.

This is not going to
become a “gold letter” for I believe that there are a different set of
constraints on gold than on other commodities. Nevertheless, the price of gold
hugged the CRB Raw Industrials Index in lock-step from 2001 to about 2007-2008.
At that point the industrial commodities declined in sympathy to the then
economic slowdown. Gold continued to rise until 2011. One might suggest it is when
those that view gold not primarily as a commodity but a hedge against the
decline in the value of currency became the dominant buyer as the US entered
various phases of “quantitative easing.” Since that peak the price of the metal
has had a parallel decline to the industrial materials. Gold bullion may have
suffered the ultimate substitution by the increase use of “paper gold” in the
form of futures and Exchange Traded Funds (ETFs) which absorbed some of the
demand for currency safety.

China has become the pivot
for commodity prices including grains. The command society shift from
manufactured exports and internal infrastructure to consummation of goods and
services has changed the global demand for industrial commodities. At some
point this shift will meet its logical end and we will see growth in commodity
imports into China. In the meantime the other developing economies will need to
import commodities to fill the needs of their growing populations.

I do not know when
commodity prices will turn upward, but as a student of history, I believe they
will. If that happens at the same time as the lust to own securities deemed in
short supply, we could have one enormous market rise which we will need before
we have a generational type of decline.

Question
of the week: Where are you seeing signs of growing
demand? (The Mall at Short Hills was crowded on a warm and clear Sunday,
today.)

Sunday, July 19, 2015

Some
pseudo-sophisticate might say the most dangerous time to trade any market is
when it is open for trading. For traders initiating a trade that can be costly
to unwind, there is no worse time than when the market is slow, with little
volume and in a long, flat pattern. The very trap of being the worse time could
also be the best time for investors.

For
Traders

For many years I have watched the actions of traders on various
broker/dealer trading desks. At times their biggest risk is boredom. In a slow, flat market (which we
have had for some time) watching their screens, reporting only minor price changes can drive these
activists crazy. To create some action they find prices that they follow
closely which they believe they understand better than the market and create a
long position or in a minor number of cases a short position. Because the
traders need to earn more than the cost of capital assigned to them they
multiply the small expected moves by the use of borrowed capital in some form.
A swift breakout or breakdown from the price level of their position can have a
dramatic impact on the value of their positions, the bonuses, and ultimately
their employment. In the current environment the trading desks staffed with
portfolio managers at hedge funds play similar games as the old dealer desks,
except with more modern training they are likely to use derivatives as their
medium.

For
Investors

Perhaps the key
difference between a trader and an investor is the time to success (or
failure). The trader is short-term oriented in terms of hours, days, or
possibly weeks. An investor is much more concerned in terms of years, often a
number of years, which is why we developed the Lipper Time Span PortfoliosTM
concept. We manage money for the long-term, and in some cases beyond one’s
lifetime. However, the long-term starts with now, at today’s price.

Jumping
Off Point

We have written in past
posts that it is somewhat natural to be in a reasonably flat stock price
picture. Equity prices have raced ahead of the slow, uncertain economic factors
that are producing limited gains in top line revenues. Current prices reflect
largely present and expected earnings gains coming from profit margin increases
due to low commodity prices, more efficient use of labor, foreign earnings
translated into US dollars, and buy-backs. Without future revenue gains much of
the above-earnings increase elements will eventually reverse.

Two
Bullish Strategies

The strategists at
Charles Schwab believe that we will enjoy a grinding higher stock market. With
core inflation, excluding food and energy, growing at a current 2.3% rate, Schwab
and most of the rest of the strategists are looking forward to the early stages
of an interest rate rise. Also the sentiment index of home builders is rising
at a faster rate than new starts.

The strategists at JP
Morgan proclaim that they are global investors to some degree, escaping the
geographic labeling in asset allocation. Nevertheless, they point out that for
many of the normal investment measures, US stocks are priced above their
ten-year averages. On the other hand they point out that the Asian Emerging
Market stocks are selling below their ten year averages in terms of forward
price/earnings ratios, price/book value, and price/cash flow. This Asian bias
is similar to our own which favors Asia over Europe, even though a number of
the funds we use are currently betting in favor of Europe.

Two
Causes of Concern

The first is Moody’s
has raised its forward looking ratio of default frequencies for US and Canadian
High Yield issues. From an abnormally low level the expected rate increase is
back in the more normal range. This could be influenced by a concern for the oil
and gas High Yield paper or too accommodative underwriting standards in the past. I tend to pay attention to
the fixed income market from the perspective of an equity investor. Often the
risk avoidance mechanisms of bond holders and traders act as the canary in the
stock market.

The second cause for
concern is much more complex and controversial. It starts with the relief rally
the world stock markets delivered for the week ending July 15thas reported by The Economist. All 44 of
markets it tracks rose for the week in US dollar terms. Only 9 declined in
local currency terms. As a contrarian, any time I see all of the passengers in
a boat on one side I fear a collapse. Many market participants view the news of
the week positive from Greece, China, and Iran. Perhaps, the US Mutual Fund and
Exchange Traded Fund investors were using the relief rallies to be net
redeemers of both domestic and international funds for the first time. Maybe
they are right or at least raising the same questions that I do in terms of
Greece, China, and Iran.

The decision to fund
Greece’s place in the euro with German money in the long run, in my opinion
weakens the euro and will not correct the larger than treaty permitted deficits
for a number of European countries. The cost of losing Greece for awhile is
much smaller than the damage in keeping it.

In many ways the
current Chinese government is the most effective government in the world. This
may be true due to its command structure or the skills of the present
leadership learned at the party’s political school. I am afraid what has been
taught is the use of socially determined bailout mechanisms. Bailouts
perpetuate poor behavior and in the end prove to be more costly to the society
than letting failures occur. In quick order they will be replaced by newer and
sounder forces.

In terms of the
agreement with Iran, my fear is that we have seen this movie before in terms of
our experiences in and after WWI and the creation of WWII.

Once again we are
experiencing the power and “wisdom” of an unelected woman in terms of the
second Mrs. Wilson (VJ) and the lack of understanding by Neville Chamberlin (VJ
and crew). The temporary avoidance of conflict comes at a much larger price of future
innocent deaths.

As we have not yet
raised cash, and since Gold and TIPS are not rising in price, let us hope that
I am wrong.

Questions
of the week:

1. How are you going to
“play” the change in direction of the current market?

Sunday, July 12, 2015

In building a portfolio of funds for clients, essentially the choices are to
choose leaders, managers or a mix.

Leaders

This last weekend may
show my inclination. We spent the weekend with our enlarged family group
of forty-seven, some or all participated in visits to George Washington's home
in Mount Vernon, the US Marine Corps oldest base at 8th and I street in
Washington for the sunset parade and silent drill team demonstration, and the
National Museum of the Marine Corps.

One could build an entire leadership course based on George Washington's life
and pursuits. While much has already been written on these topics, for us
involved with investing, two themes merit our review. The first is
aggressiveness. Before and after his military battles during the American
Revolution Washington was an aggressive investor in land. At the time of his
death he owned some 70,000 acres all the way into the Ohio Valley. Many of the
land parcels he had surveyed years before, but some were virgin territory
for him. Unfortunately while he believed in both physical as well as
financial planning, he died with lots of land and some debts and very
little cash, thus much of his assets had to be liquidated without further
development in order to meet his debts. As with most leaders he was ahead of
his time focusing on the potential of future development. (He could have
used a more competent cash manager.)

Discipline

I have often written about the second important aspect of Washington’s
leadership, discipline, which I have learned from my active duty service
in the US Marine Corps. On this trip the skills and bravery of the individual
Marine was an important focus. The National Museum of the Marine Corps in their
displays depicted the bravery and fighting skills of individual Marines. In
addition to listening to the very talented Marine Band and the Drum & Bugle
Corps, one of the highlights was watching the silent drill team's parade.
This platoon of perfectly selected young Marines go through their
routines with no audio commands issued. Their memory of endless rehearsals and
the discipline to follow ingrown procedures produced a striking tableau. In
addition to the Marine Corps Commandant, the honored guests included a sizable
number of members of Congress who one point wore the US Marine uniform. Perhaps
it was no accident that the current Commandant, General Joseph Dunford has been
nominated to be the Chairman of the Joint Chiefs of Staff pending the
approval of the US Senate. In that role he will become the chief military
advisor to the US President.

At
the end of the evening the Commissioned Officers marched away and were replaced
by the leading Non-Commissioned Officers to march off the troops returning to
the barracks. These NCOs are the real managers of the infantry. They get the
job done accomplishing the officers’ orders.

Do you want Leaders or Managers Managing Your Portfolio?

I sit on a number of investment committees as well as managing discretionary
accounts of portfolios of funds. One of the characteristics of investment
committees is that there is a strong desire for them to reach unanimous
decisions. Often there are official or unofficial benchmarks that become
performance targets. All too many investment committees react politically by
agreeing to the least aggressive strategy, with emphasis on beating a benchmark
regardless of the nature of the account or composition and management of the
benchmark. By adopting this strategy they are really making the decision
in favor of managers who will be graded on how close they come over time to the benchmark. As all too often the benchmark is of individual securities that are
assembled without management and trading expenses they are also without the
auditing standards normally used by professional organizations. In addition,
not much attention is paid to component weights and methodology and the timing
of additions and deletions. The drags caused by expenses and the desirability
for some operating cash makes it quite difficult for most managers over time to
beat securities benchmarks.

If you wish to have superior results from specific portfolios which do not have
the low expense ability and/or the need for operational cash, one should
take the risks of going with leaders. Leaders are managers doing some things
differently than the normal (not currently the best) performers. Because of
their relative isolation, leaders can often be strong personalities with some
missionary zeal. A complicating factor in choosing a potential future
leader is that often they are not the smooth presenting managers that garner so
much of the institutional money. Further, most of the time they have little or
uneven performance records. The key to their selection rests on their well
thought-out, but different investment approaches.

What Do We Do?

We build a mix of managers and leaders. The managers are selected on the basis
of their expense control and their ability to reasonably hug the benchmark.
These are then combined with managers that we believe will have a good chance
to be future performance leaders.

Question of the week:
Can we discuss our approach with you as applied to your investments?

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About Mike Lipper

A. Michael Lipper is a CFA charterholder and the president of Lipper Advisory Services, Inc., a firm providing money management services for wealthy families, retirement plans and charitable organizations.

A former president of the New York Society of Security Analysts, Mike Lipper created the Lipper Growth Fund Index, the first of today’s global array of Lipper Indexes, Averages and performance analyses for mutual funds.

After selling his company to Reuters in 1998, Mike has focused his energies on managing the investments of his clients and his family. His first book, MONEY WISE: How to Create, Grow and Preserve Your Wealth (St. Martin's Press) was published in September, 2008.

Mike’s unique perspectives on world markets and their implications have been posted weekly at Mike Lipper’s Blog since August, 2008. Join Mike Lipper’s community and subscribe to this blog via email or RSS by clicking below.
Mike encourages reader comment; please use either the comment feature on his blog or reach him directly at aml@lipperadvising.com.